- The early 2023 stocks rally will prove short-lived, so investors should pivot to bonds, Lisa Shalett said.
- Further Federal Reserve tightening is set to weigh on stocks, the Morgan Stanley Wealth Management CIO said.
Investors should pivot away from stocks to bonds, as markets are still blindly fighting the Federal Reserve despite policymakers' commitment to hiking and holding interest rates if needed, a top Morgan Stanley strategist has said.
Morgan Stanley Wealth Management investment chief Lisa Shalett is still cautious about equities despite an early-year rally fueled by the expectation that the cost of borrowing will have started falling by the end of 2023.
"Problematically, equity and credit markets are aggressively fighting the Fed, with valuations only supported by assumptions of ample rate cuts," she wrote in a research note Monday.
"History suggests these strategies often end in disappointment as cause and effect are conflated."
The old adage "Don't fight the Fed" refers to the idea that investors should align their portfolios to benefit, rather than lose out, from the US central bank's monetary policies.
The Fed raised interest rates from near-zero in March to 4.50-4.75% currently, hinting more hikes could still come. Some policymakers have signaled the US central bank will raise borrowing costs above 5% and then hold them there for the whole of 2023, in a bid to tame US inflation to its 2% target level.
Equities tend to suffer when the Fed tightens, because it's costlier for companies to borrow cash.
But the stock market has pushed back against that assumption so far in 2023. The benchmark S&P 500 US equity index has climbed just under 8% and the tech-heavy Nasdaq Composite has rallied nearly 14% year-to-date.
Most stocks look overpriced at their current valuations, according to Shalett. The companies listed on the S&P 500 currently have a forward price/earnings multiple of 18.5 – slightly higher than the index's 10-year average of 16.9.
"Rich valuations offer little room for error, as bullish risk-taking counters central bank guidance," Shalett said. "Folklore suggests not to fight the Fed for a reason."
The wealth management CIO believes markets are caught up in a period of "thick fog", where investors struggle to figure out how rising interest rates, sticky inflation and the threat of a potential recession will impact stocks.
"The thick fog induced by economic and market crosscurrents leads to trends driven by sentiment, positioning, liquidity and other technical factors, as investors try to anticipate the anticipation," Shalett said.
"2023 may be such a period of dense fog," she added.
Investors should load up on bonds — which tend to offer steadier returns at a lower risk premium — rather than holding onto potentially overvalued stocks, according to Morgan Stanley.
Shalett recommended owning short- to medium-term US Treasurys, municipal bonds, and corporate credits, as well as equities that could potentially pay out above-average dividends.